The application of insurance as a risk management tool for alternative dispute resolution (ADR) implementation in construction disputes

In modern days, construction projects have become more and more complex and intriguing. One source of the complexity arises from the large number of parties involved. This is especially the case for large-scale construction projects. Because of such complexity, disputes are almost inevitable and implementation costs associated with dispute resolution have become increasingly expensive. Because most projects operate on tight budgets, cost effective dispute resolution plays an important role in the success of a construction project. For this purpose, Alternative Dispute Resolution (ADR) techniques such as negotiation, mediation, and arbitration are being widely adopted in large-scale construction projects to resolve disputes in more effective and cost-saving ways. However, the risk of incurring dispute-related cost overruns always exists because of the uncertainty in the distribution of dispute occurrence and the effectiveness of contractually-predetermined ADR techniques. As a result, the traditional self-insured structure which simply retains all dispute resolution costs to the project through contingency fees is no longer considered economical. While many insurance policies cover the settlement of a dispute, such as professional liability insurance, no specific insurance policy is dedicated to cover the ADR implementation costs such as fees and expenses that are paid to the owner/contractor's employees, lawyers, claims consultants, third party neutrals, and other experts involved in the resolution process. To fill the gap, this dissertation proposes an insurance model to reduce the potential variations in the dispute resolution budget by pricing ADR techniques as an insurance product. It is designed to transfer the risk of dispute-related cost overruns from the project to a third-party insurance company. To achieve this goal, this dissertation focuses on three major tasks: 1) investigate the role of ADR implementation insurance in construction risk management, 2) construct a mathematical model to represent the risk attitudes of project participants using utility theory and derive the basic premium of ADR implementation insurance using insurance pricing theory, and 3) develops a comprehensive framework to determine the optimal insurance premium by considering two additional insurance limits — a Deductible Limit (DL) and a Maximum Payment Limit (MPL). The objective of this dissertation is to provide project participants with an advantageous insurance policy that minimizes their total expected subjective loss. The model can serve as a decision-making support system to help project participants determine whether an ADR implementation insurance policy is attractive for a certain project. To illustrate the benefits of the proposed model, numerical examples are provided for simulation purpose. The results show that ADR implementation insurance, although not a tool to eliminate dispute resolution costs, is a powerful alternative in risk management to transfer the financial implications of ADR implementation risk to a third party.